In short, depreciation is an accounting method that helps you offset the cost of an asset over the timespan of its useful life.
When a business purchases an asset such as a vehicle, a piece of machinery, or a piece of office equipment, that asset decreases in value over time due to regular use, wear, and tear.
Depreciation is used to help businesses recover the loss of business assets such as equipment and machinery over a period of time.
How Does Depreciation Work?
Depreciation is a tax deduction that lowers your taxable income. It applies to large assets you would use in your business; assets that have a lifespan of longer than one year.
When your accountant calculates and uses depreciation in your books, you can recover the loss of value on assets as you use them and lower your tax burden in the process.
Related Article: Meals And Entertainment Deduction For Business: Does It Still Exist?
What Types Of Assets Can Be Depreciated?
Not all assets your business uses can be depreciated. The IRS has rules for what types of assets you can depreciate. Here are some of the rules regarding depreciation in business:
- The assets must be owned by you/your company
- The assets must be used for company business
- Each asset must have a determinable (by you) lifespan
Some examples of depreciable assets include:
- Vehicles used for business
- Office equipment such as computers, printers, and furniture
- Machinery and similar items
- Computer software
- Office buildings
Some examples of non-depreciable assets include:
- Land (it typically does not depreciate)
- Assets and equipment with a lifespan of less than one year
Talk with your tax accountant to further define which types of assets are depreciable, and which are non-depreciable.
Depreciation Of Building Repairs And Improvements
You can also use depreciation when it comes to improvements on a building you use for your business. However, you can not depreciate the expenses for most repairs on a building.
For instance, if you need to repair a leak in your building’s roof, you can deduct the expenses you paid to have the roof repaired. On the other hand, if you need to replace the entire roof that cost doesn’t qualify as a repair.
Instead, the replaced roof would be considered a fixed business asset that would depreciate over time. So you would regain some of that cost by using depreciation of the roof’s value over the course of the years, depending on the method of depreciation your account uses.
How Does Depreciation Benefit Me From A Tax Perspective?
Taking depreciation on your fixed assets can lower your taxable income over many years versus a substantial decrease in the current year.
Lowering your taxable income lowers your tax liability as well. Using depreciation can be very helpful in creating a tax strategy for your business. Be sure to discuss with your tax accountant to determine what is best for your business and tax situation.
Related Article: Are You Missing These Common Self-Employed Tax Deductions?
Main Methods Of Depreciation
There are two main methods of depreciation people use in business: MACRS (Modified Accelerated Cost Recovery System) and Straight Line Depreciation.
There’s also a third type of depreciation called the Section 179 Deduction. We’ll talk about that method as well.
There are other less commonly used types of depreciation you can learn about from your accountant. However, we’ll stick with the basics in this article.
MACRS (Modified Accelerated Cost Recovery System)
MACRS is probably the most common type of depreciation used by businesses.
This type of depreciation is more commonly used for businesses that want or need to deduct more of an asset’s value up front. This method also recognizes that assets decline more in their first years of use than in later years of use.
For example, let’s say you purchased a piece of machinery for your business. The piece of machinery cost $100,000. The item has an estimated useful life of 20 years and an estimated salvageable value of $8,000.
So, you can deduct $92,000 for the value of the piece of machinery over a 7-year period. For the first year, you might deduct $25,000. The second year, you’d deduct $20,000. Then you’d divide the other $57,000 in deductions over the next five years, declining the amount each year.
During the final year of depreciation on the item, you’d deduct the smallest amount.
Here’s a MACRS calculator if you want to run some numbers.
Straight Line Depreciation
Straight line depreciation is probably the second most common type of depreciation among businesses. It’s also the easiest to use.
With straight line depreciation the formula is simple: Cost of the asset, minus salvage value (what you’ll be able to sell it for at its end of life), divided by the number of years of depreciation.
Let’s say you buy a truck for your business for $50,000. The estimated salvageable value at the end of five years (your estimate on its useful life) would be $10,000. $50,000 minus $10,000 is $40,000. You divide that $40,000 by five years, which results in a depreciation deduction of $8,000 per year.
$50,000 – $10,000 = $40,000 / 5 = $8,000 per year
Although this type of depreciation is based largely on guesswork, it is one of the most common and easiest to use methods of depreciation.
Here is a straight line depreciation calculator that will do these calculations for you.
Section 179 Deduction
The Section 179 Deduction works a bit differently. If you qualify, this depreciation deduction allows you to write off the entire cost of the asset during the same year.
There are limits and rules to the Section 179 Deduction that your tax accountant can talk over with you to see if this depreciation deduction may be beneficial for your business.
Here is some info about this deduction from the IRS.
How To Sell A Depreciated Item And How To Record That On Your Taxes
At the end of its lifespan, you may decide to sell your depreciated asset. How does that affect your taxes? Well, that depends on any profit or loss you made after considering depreciation.
For instance, let’s say your estimated salvageable value on an item that was depreciated for five years was $0. If you give it away, your accountant will show a zero effect on your taxes.
If you sell it for $10,000, your accountant will show a $10,000 profit on your taxes.
Conversely, if the salvageable value of your depreciated item at the end of the depreciation term was $5,000. If you gave the item away, you’d take a $5,000 loss on your taxes.
As with all depreciation work on your taxes, calculating your tax burden or benefit when selling depreciable items is best left to a professional tax accountant to analyze and record.
How To Track Depreciation In Your Accounting Software
Here’s the thing: Most accounting software programs don’t have a feature that will track depreciation for you. However, many accounting software programs have areas where you can manually track depreciation. But again, you’ll want to ensure depreciation tracking is done correctly.
For that reason, we recommend having your accountant track depreciation for you. Incorrect recording and tracking of depreciation can result in tax filing errors and a visit from the IRS.
Using a qualified accounting service like Cloud Friday is of the utmost importance if you want to take full advantage of the benefits of depreciation.
Besides the fact that a qualified accountant can ensure you’re recording depreciation and other business financials correctly and legally, he or she can also reduce your stress levels dramatically by taking that task off of your hands.
Don’t leave your business tax return accuracy to chance. Use professional accounting services to ensure all is recorded, analyzed, and filed correctly.
Using depreciation in accounting is a smart way to get the most financial benefit out of the equipment you buy and use for your business. But in order to maximize the benefits of depreciation for your business, you need to know all of the intricate details of when, where, and how to use depreciation.
Tax laws regarding depreciation can change each year. And the varying types of depreciation can benefit different businesses in different manners. In other words, you might not know what types of depreciation can benefit your business, and how, until you talk with your tax accountant.
Contact us for more information on depreciation rules and benefits for your business. Be sure you’re taking full advantage of the tax benefits due to you as a business owner.